Monetary Policy Report submitted to the Congress on July 22, 1999,
pursuant to the Full Employment and
Balanced Growth Act of 1978

Section 2

ECONOMICANDFINANCIALDEVELOPMENTSIN1999

The economy has continued to grow rapidly so far
this year. Real gross domestic product rose more than 4 percent
at an annual rate in the first quarter of 1999, and available data
point to another significant gain in the second
quarter. 1 The rise in activity has been brisk
enough to produce further substantial growth of employment and a
reduction in the unemployment rate to 4-1/4 percent. Growth
in output has been driven by strong domestic demand, which in turn has
been supported by further increases in equity prices, by the continuing
salutary effects of government saving and inflows of foreign investment
on the cost of capital, and by more smoothly functioning financial
markets as the turbulence that marked the latter part of 1998 subsided.
Against the background of the easing of monetary policy last fall and
continuing robust economic activity, investors became more willing
to advance funds to businesses; risk spreads have receded and
corporate debt issuance has been brisk.

Inflation developments were mixed over the first half of the
year. The consumer price index increased more rapidly owing to a sharp
rebound in energy prices. Nevertheless, price inflation outside of the
energy area generally remained subdued despite the slight further
tightening of labor markets, as sizable gains in labor productivity and
ample industrial capacity held down price increases.

The Household Sector

Consumer Spending

Real personal consumption expenditures surged
6-3/4 percent at an annual rate in the first quarter, and
more recent data point to a sizable further advance in the second
quarter. The underlying fundamentals for the household sector have
remained extremely favorable. Real incomes have continued to rise
briskly with strong growth of employment and real wages, and consumers
have benefited from substantial gains in wealth. Not surprisingly,
consumer confidence--as measured, for example, by the
University of Michigan Survey Research Center (SRC) and Conference
Board surveys--has remained quite upbeat in this environment.

Growth of consumer spending in the first quarter was strong in
all expenditure categories. Outlays for durable goods rose
sharply, reflecting sizable increases in spending on electronic
equipment (especially computers) and on a wide range of other goods,
including household furnishings. Purchases of cars and light trucks
remained at a high level, supported by declining relative prices as
well as by the fundamentals that have buoyed consumer spending more
generally. Outlays for nondurable goods were also robust, reflecting in
part a sharp increase in expenditures for apparel. Finally, spending on
services climbed steeply as well early this year, paced by sizable
increases in spending on recreation and brokerage services. In the
second quarter, consumers apparently boosted their purchases of motor
vehicles further. In all, real personal consumption expenditures rose
at more than a 4 percent annual rate in April and May, an
increase that is below the first-quarter pace but is still quite rapid
by historical standards.

Real disposable income increased at an annual rate of
3-1/2 percent in the first quarter, with the strong labor
market generating marked increases in wages and salaries. Even so,
income grew less rapidly than expenditures, and the personal saving
rate declined further; indeed, by May the saving rate had moved below
negative 1 percent. Much of the decline in the saving rate in
recent years can be explained by the sharp rise in household net worth
relative to disposable income that is associated with the
appreciation of households' stock market assets since 1995.
This rise in wealth has given households the wherewithal to spend at
levels beyond what current incomes would otherwise allow. As share
values moved up further in the first half of this year, the
wealth-to-income ratio continued to edge higher despite the absence of
saving out of disposable income.

Residential Investment

Housing activity remained robust in the first
half of this year. In the single-family sector, positive fundamentals
and unseasonably good weather helped boost starts to a pace of
1.39 million units in the first quarter--the highest level of
activity in twenty years. This extremely strong level of building
activity strained the availability of labor and some materials; as a
result, builders had trouble achieving the usual seasonal increase in
the second quarter, and starts edged off to a still-high pace of
1.31 million units. Home sales moderated in the spring: Sales of
both new and existing homes were off some in May from their earlier
peaks, and consumers' perceptions of homebuying conditions as measured
by the Michigan SRC survey have declined from the very high marks
recorded in late 1998 and early this year. Nonetheless, demand has
remained quite robust, even in the face of a backup in mortgage
interest rates: Builders' evaluations of new home sales remained very
high at mid-year, and mortgage applications for home purchases showed
strength into July.

With strong demand pushing up against limited capacity, home
prices have risen substantially, although evidence is mixed as to
whether the rate of increase is picking up. The quality-adjusted price
of new homes rose 5 percent over the four quarters ended
in 1999:Q1, up from 3-1/4 percent over the preceding
four-quarter period. The repeat sales index of existing home prices
also rose about 5 percent between 1998:Q1 and 1999:Q1, but this
series posted even larger increases in the year-earlier period. On the
cost side, tight supplies have led to rising prices for some building
materials; prices of plywood, lumber, gypsum wallboard, and insulation
have all moved up sharply over the past twelve months. In addition,
hourly compensation costs have been rising relatively rapidly in the
construction sector.

Starts of multifamily units surged to 384,000 at an annual rate
in the first quarter and ran at a pace a bit under 300,000 units in the
second quarter. As in the single-family sector, demand has been
supported by strong fundamentals, builders have been faced with tight
supplies of some materials, and prices have been rising briskly:
Indeed, apartment property values have been increasing at around a
10 percent annual rate for three years now.

Household Finance

In addition to rising wealth and rapid income growth, the strong
expenditures of households on housing and consumer goods over the first
half of 1999 were encouraged by the decline in interest rates in the
latter part of 1998. Households borrowed heavily to finance spending.
Their debt expanded at a 9-1/2 percent annual rate in the
first quarter, up from the 8-3/4 percent pace over 1998,
and preliminary data for the second quarter indicate continued robust
growth. Mortgage borrowing, fueled by the vigorous housing market and
favorable mortgage interest rates, was particularly brisk in the first
quarter, with mortgage debt rising at an annual rate of 10
percent. In the second quarter, mortgage rates moved up considerably,
but preliminary data indicate that borrowing was still substantial.

Consumer credit growth accelerated in the first half of 1999. It
expanded at about an 8 percent annual rate compared with
5-1/2 percent for all of 1998. The growth of
nonrevolving credit picked up, reflecting brisk sales and
attractive financing rates for automobiles and other consumer durable
goods. The expansion of revolving credit, which includes credit card
loans, slowed a bit from its pace in 1998.

Households apparently have not encountered added difficulties
meeting the payments associated with their greater indebtedness, as
measures of household financial stress improved a bit on balance in the
first quarter. Personal bankruptcies dropped off considerably,
although part of the decline may reflect the aftermath of a surge in
filings in late 1998 that occurred in response to pending legislation
that would limit the ability of certain debtors to obtain forgiveness
of their obligations. Delinquency rates on several types of household
loans edged lower. Delinquency and charge-off rates on credit card debt
moved down from their 1997 peaks but remained at historically high
rates. A number of banks continued to tighten credit card lending
standards this year, as indicated by banks' responses to Federal
Reserve surveys.

The Business Sector

Fixed Investment

Real business fixed investment
appears to have posted another huge increase over the first half
of 1999. Investment spending continued to be driven by
buoyant expectations of sales prospects as well as by rapidly
declining prices of computers and other high-tech equipment. In
recent quarters, spending also may have been boosted by the desire to
upgrade computer equipment in advance of the rollover to the year
2000. Real investment has been rising rapidly for several years now;
indeed, the average increase of 10 percent annually over the past five
years represents the most rapid sustained expansion of investment in
more than thirty years. Although a growing portion of this investment
has gone to cover depreciation on purchases of short-lived
equipment, the investment boom has led to a notable upgrading and
expansion of the capital stock and in many cases has
embodied new technologies. These factors likely have been important in
the nation's improved productivity performance over the past few years.

Real outlays for producers' durable equipment increased at an
annual rate of 9-1/2 percent in the first quarter of the
year, after having surged nearly 17 percent last year, and may
well have re-accelerated in the second quarter. Outlays on
communications equipment were especially robust in the first quarter,
driven by the ongoing effort by telecommunications companies to upgrade
their networks to provide a full range of voice and data
transmission services. Purchases of computers and other information
processing equipment were also up notably in the first quarter, albeit
below last year's phenomenal spending pace, and shipments of computers
surged again in April and May. Shipments of aircraft to domestic
carriers apparently soared in the second quarter, and business spending
on motor vehicles, including medium and heavy trucks as well as
light vehicles, has remained extremely strong as well.

Real business spending for nonresidential structures has been
much less robust than for equipment, and spending trends have varied
greatly across sectors of the market. Real spending on office buildings
and lodging facilities has been increasing impressively, while spending
on institutional and industrial structures has been declining--the last
reflecting ample capacity in the manufacturing sector. In the first
quarter of this year, overall spending on structures was reported in
the national income and product accounts to have moved up at a solid
5-3/4 percent annual rate, reflecting a further sharp
increase in spending on office buildings and lodging facilities.
However, revised source data indicate a somewhat smaller first-quarter
increase in nonresidential construction and also point to a slowing in
activity in April and May from the first-quarter pace.

Inventory Investment

Inventory-sales ratios in
many industries dropped considerably early this year, as the pace of
stockbuilding by nonfarm businesses, which had slowed notably over
1998, remained well below the surge of consumer and business spending
in the first quarter. Although production picked up some in the spring,
final demand remained quite strong, and available monthly data suggest
that businesses accumulated inventories in April and May at a rate not
much different from the modest first-quarter pace.

In the motor vehicle sector, makers geared up production in the
latter part of 1998 to boost inventories from their low levels after
last summer's strikes. Nevertheless, as with the business sector
overall, motor vehicle inventories remained on the lean side by
historical standards in the early part of this year as a result of
surprisingly strong vehicle sales. As a consequence, manufacturers
boosted the pace of assemblies in the second quarter to the
highest level in twenty years. With no noticeable signs of a
slowing in demand, producers have scheduled third-quarter output to
remain at the lofty heights of the second quarter.

Corporate Profits and Business Finance

The economic profits of nonfinancial U.S.
corporations rose considerably in the first quarter, even after
allowing for the depressing effect in the fourth quarter of
payments associated with the settlement between the tobacco companies
and the states. Despite the growth of profits, capital expenditures
by nonfinancial businesses continued to outstrip internal cash flow.
Moreover, borrowing requirements were enlarged by the net reduction in
equity outstanding, as the substantial volume of retirements from
merger activity and share repurchase programs exceeded the
considerable volume of gross issuance of both initial and seasoned
public equities. As a result, businesses continued to borrow at a brisk
pace: Aggregate debt of the nonfinancial business sector expanded
at a 9-1/2 percent annual rate in the first quarter. As
financial market conditions improved after the turmoil of the fall,
businesses returned to the corporate bond and commercial paper markets
for funding, and corporate bond issuance reached a record high in
March. Some of the proceeds were used to pay off bank loans, which had
soared in the fall, and these repayments curbed the expansion of
business loans at banks. Partial data for the second quarter indicate
that borrowing by nonfinancial businesses slowed somewhat.

Risk spreads have receded on balance this year
from their elevated levels in the latter part of 1998. From the
end of December 1998 through mid-July, investment-grade corporate bond
yields moved up from historically low levels, but by less than yields
on comparable Treasury securities, and the spread between these yields
narrowed to a level somewhat above that prevailing before the
Russian crisis. The rise in investment-grade corporate bond
yields was restrained by investors' apparently increased
willingness to hold such debt, as growing optimism about the economy
and favorable earnings reports gave investors more confidence about the
prospective financial health of private borrowers. Yield spreads
on below-investment-grade corporate debt over comparable Treasury
securities, which had risen considerably in the latter part
of 1998, also retreated. But in mid-July, these spreads were still well
above the thin levels prevailing before the period of financial turmoil
but in line with their historical averages.

In contrast to securities market participants, banks' attitudes
toward business lending apparently became somewhat more cautious over
the first half of the year, according to Federal Reserve surveys. The
average spread of bank lending rates over the FOMC's intended federal
funds rate remained elevated. On net, banks continued to tighten
lending terms and standards this year, although the percentage that
reported tightening was much smaller than in the fall.

The overall financial condition of nonfinancial businesses was
strong over the first half of the year, although a few indicators
suggested a slight deterioration. In the first quarter, the ratio
of net interest payments to corporate cash flow remained close to the
modest levels of 1998, as low interest rates continued to hold down
interest payments. Delinquency rates for commercial and industrial
loans from banks ticked up, but they were still modest by
historical standards. Similarly, over the first half of the year,
business failures--measured as the ratio of liabilities of failed
businesses to total liabilities--stepped up from the record low in
1998. The default rate on below-investment-grade bonds rose to its
highest level in several years, an increase stemming in part from
defaults by companies whose earnings were impaired by the drop in oil
and other commodity prices last year. The total volume of business debt
that was downgraded exceeded slightly the volume of debt that was
upgraded.

The Government Sector

Federal Government

The incoming news on the federal budget continues to be quite
favorable. Over the first eight months of fiscal year 1999--the period
from October through May--the unified budget registered a surplus of
about $41 billion, compared with $16 billion during the
comparable period of fiscal 1998. If the latest projections from the
Office of Management and Budget and the Congressional Budget Office are
realized, the unified budget for fiscal 1999 as a whole will show a
surplus of around $100 billion to $120 billion, or more
than 1 percent of GDP--a striking turnaround from the outsized
budget deficits of previous years, which approached 5 percent of
GDP in the early 1990s.

As a result of this
turnaround, the federal government is now contributing positively to
the pool of national saving. In fact, despite the recent drop in the
personal saving rate, gross saving by households, businesses, and
governments has remained above 17 percent of GDP in recent
quarters--up from the 14 percent range that prevailed in the
early 1990s. This well-maintained pool of national savings,
together with the continued willingness of foreigners to finance
our current account deficits, has helped hold down the cost of capital,
thus contributing to our nation's investment boom.

This year's increase in the federal surplus has reflected
continued rapid growth of receipts in combination with a modest
increase in outlays. Federal receipts were 5 percent higher in
the first eight months of fiscal 1999 than in the year-earlier period.
With profits leveling off from last year, receipts of corporate
taxes have stagnated so far this fiscal year. However,
individual income tax payments are up appreciably, reflecting the solid
gains in household incomes and perhaps also a rise in capital gains
realizations large enough to offset last year's reduction in capital
gains tax rates. At the same time, federal outlays increased only
2-1/2 percent in nominal terms and barely at all in real
terms during the first eight months of the fiscal year, relative to the
comparable year-earlier period. Spending growth has been restrained in
major portions of both the discretionary (notably, defense) and
nondiscretionary (notably, net interest, social security, and Medicare)
categories--although this year's emergency supplemental spending bill,
at about $14 billion, was somewhat larger than similar bills in
recent years.

As for the part of federal spending that is counted in GDP, real
federal outlays for consumption and gross investment, which had changed
little over the past few years, declined at a 2 percent annual rate
in the first quarter of 1999. A drop in real defense outlays more
than offset a rise in nondefense expenditures in the first quarter.
And despite the military action in the Balkans and the recent emergency
spending bill, defense spending appears to have declined in the second
quarter as well.

The budget surpluses of the past two years have led to a notable
decline in the stock of federal debt held by private investors as a
share of GDP. Since its peak in March 1997, the total volume of
Treasury debt held by private investors has fallen by nearly $130
billion. The Treasury has reduced its issuance of interest-bearing
marketable debt in fiscal 1999. The decrease has been
concentrated in nominal coupon issues; in 1998, by contrast, the
Treasury retired both bill and coupon issues in roughly equal
measure. Offerings of inflation-indexed securities have remained an
important part of the Treasury's overall borrowing program: Since the
beginning of fiscal 1999, the Treasury has sold nearly $31
billion of such securities.

State and Local Governments

The fiscal condition of state and local governments has
remained quite positive as well. Revenues have been boosted by
increases in tax collections due to strong growth of
private-sector incomes and expenditures--increases that were enough to
offset an ongoing trend of tax cuts. Meanwhile, outlays have continued
to be restrained. In all, at the state level, fiscal 1999 looks to have
been the seventh consecutive year of improving fiscal positions; of the
forty-six states whose fiscal years ended on June 30, all appear
to have run surpluses in their general funds.

Real expenditures for consumption and gross investment by states
and localities, which had been rising only moderately through most of
1998, jumped at a 7-3/4 percent annual rate in the first
quarter of this year. This increase was driven by a surge in
construction expenditures that was helped along by unseasonably
favorable weather, and spending data for April and May suggest that
much of this rise in construction spending was offset in the second
quarter. As for employment, state and local governments added jobs over
the first half of the year at about the same pace as they did last
year.

Debt of state and local governments expanded at a
5-1/2 percent rate in the first quarter. The low interest
rate environment and strong economy encouraged the financing of new
projects and the refunding of outstanding higher-rate debt. Borrowing
slowed to a more modest pace in the second quarter, as yields on
long-dated municipal bonds moved up, but by less than those on
comparable Treasury securities. The credit quality of municipal
securities improved further over the first half of the year, with more
issues being upgraded than downgraded.

External Sector

Trade and the Current Account

The current account deficit reached $274 billion at
an annual rate in the first quarter of 1999, a bit more than 3
percent of GDP, compared with $221 billion and 2-1/2
percent of GDP for 1998. A widening of the deficit on trade in goods
and services, to $215 billion at an annual rate in the first
quarter from $173 billion in the fourth quarter of 1998,
accounted for the deterioration in the current account balance. Data
for April and May indicate that the trade deficit increased further in
the second quarter.

The quantity of imports of
goods and services again grew vigorously in the first quarter. The
annual rate of growth of imports, at 13-1/2 percent,
continued the rapid pace seen over 1998 and reflected the strength of
U.S. domestic demand and the effects of past dollar appreciation.
Imports of consumer goods, automotive products, computers, and
semiconductors were particularly robust. Preliminary data for April and
May suggest that real import growth remained strong, as nominal imports
rose steadily and non-oil import prices posted a moderate decline.

The volume of exports of goods and services declined at an annual
rate of 5 percent in the first quarter. The decline partially
reversed the strong increase in the fourth quarter of last year. The
weakness of economic activity in a number of U.S. trading
partners and the strength of the dollar damped demand for U.S.
exports. Declines were registered in aircraft, machinery, industrial
supplies, and agricultural products. Exports to Asia generally turned
down in the first quarter from the elevated levels recorded in the
fourth quarter, when they were boosted by record deliveries of aircraft
to the region. Preliminary data for April and May suggest that real
exports advanced slightly.

Capital Account

Foreign direct investment in the United States
and U.S. direct investment abroad remained robust in the first quarter,
reflecting brisk cross-border merger and acquisition activity. On
balance, net capital flows through direct investment registered a
modest outflow in the first quarter compared with a huge net inflow in
the fourth quarter. Fourth-quarter inflows were swollen by several
large mergers. Net foreign purchases of U.S. securities also continued
to be quite sizable but again were well below the extraordinary pace of
the fourth quarter. Most of the slowdown in the first quarter is
attributable to a reduced demand for Treasury securities on the part of
private investors abroad. But capital inflows from foreign official
sources also slowed in the first quarter. U.S. residents on net sold
foreign securities in the first quarter, but at a slower rate than in
the previous quarter.

The Labor Market

Employment and Labor Supply

Labor demand remained very strong during the first half of 1999.
Payroll employment increased about 200,000 per month on
average, which, although less rapid than the 244,000 pace registered
over 1998, is faster than the growth of the working-age population.
With the labor force participation rate remaining about flat at just
over 67 percent, the unemployment rate edged down further from an
average of 4-1/2 percent in 1998 to 4-1/4
percent in the first half of this year--the lowest unemployment rate
seen in the United States in almost thirty years. Furthermore, the pool
of potential workers, including not just the unemployed but also
individuals who are out of the labor force but report that they want a
job, declined late last year to the lowest share of the labor force
since collection of these data began in 1970--and it has remained near
that low this year. Not surprisingly, businesses in many parts of the
country have perceived workers to be in very short supply, as evidenced
by high levels of help-wanted advertising and surveys showing
substantial difficulties in filling job openings.

Employment gains in the private
service-producing sector remained sizable in the first six months of
the year and more than accounted for the rise in nonfarm payrolls over
this period. Payrolls continued to rise briskly in the services
industry, with firms providing business services (such as help supply
services and computer services) adding jobs especially rapidly. Job
gains were quite sizable in retail trade as well. Within the
service-producing sector, only the finance, insurance, and real estate
industry has slowed the pace of net hiring from last year's rate,
reflecting, in part, a slower rate of job gains in the mortgage
banking industry as the refinancing wave has ebbed.

Within the goods-producing sector, the boom in construction
activity pushed payrolls in that industry higher in the first six
months of this year. But in manufacturing, where employment began
declining more than a year ago in the wake of a drop in export demand,
payrolls continued to fall in the first half of 1999; in all, nearly
half a million factory jobs have been shed since March 1998. Despite
these job losses, manufacturing output continued to rise in the first
half of this year, reflecting large gains in labor productivity.

Labor Costs and Productivity

Growth in hourly compensation, which had been
on an upward trend since 1995, appears to have leveled off and, by some
measures, has slowed in the past year. According to the employment cost
index (ECI), hourly compensation costs increased 3 percent over
the twelve months ended in March, down from 3-1/2 percent
over the preceding twelve-month period. Part of both the earlier
acceleration and more recent deceleration in the ECI apparently
reflected swings in commissions, bonuses, and other types of
``variable'' compensation, especially in the finance, insurance,
and real estate industry. But in addition, part of the recent
deceleration probably reflects the influence of restrained price
inflation in tempering nominal wage increases. Although down from
earlier increases, the 3 percent rise in the ECI over the twelve
months ended in March was well above the rise in prices over this
period and therefore was enough to generate solid gains in workers'
real pay.

The deceleration in the ECI through March has been most
pronounced in the wages and salaries component, whose
twelve-month change slowed 3/4 percentage point from a
year earlier. More recently, data on average hourly earnings of
production or nonsupervisory workers may point to a leveling off, but
no further slowing, of wage growth: This series was up at about a
4 percent annual rate over the first six months of this year,
about the same as the increase over 1998. Growth in the benefits
component of the ECI slowed somewhat as well in the year ended in
March, to a 2-1/4 percent increase. However, employers'
costs for health insurance are one component of benefits that has been
rising more rapidly of late. After showing essentially no change from
1994 through 1996, the ECI for health insurance accelerated to a
3-3/4 percent pace over the twelve months ended in March.

A second measure of hourly compensation--the Bureau of Labor
Statistics' measure of compensation per hour in the nonfarm business
sector, which is derived from compensation information from the
national accounts--has been rising more rapidly than the ECI in the
past few years and has also decelerated less so far this year. Nonfarm
compensation per hour increased 4 percent over the four quarters
ended in the first quarter of 1999, 1 percentage point more than
the rise in the ECI over this period. One reason these two compensation
measures may diverge is that the ECI does not capture certain forms
of compensation, such as stock options and hiring, retention, and
referral bonuses, whereas nonfarm compensation per hour does measure
these payments. 2 Although the two compensation measures
differ in numerous other respects as well, the series' divergence
may lend support to anecdotal evidence that these alternative forms of
compensation have been increasing especially rapidly in recent years.
However, because nonfarm compensation per hour can be revised
substantially, one must be cautious in putting much weight on the most
recent quarterly figures from this series.

Rapid productivity growth has made it possible to sustain
these increases in workers' compensation without placing great pressure
on businesses' costs. Labor productivity in the nonfarm business sector
posted another sizable gain in the first quarter of 1999, and the
increase over the four quarters ended in the first quarter of 1999 was
2-1/2 percent. Indeed, productivity has increased at a
2 percent pace since 1995--well above the trend of roughly
1 percent per year that had prevailed over the
preceding two decades. 3 This recent productivity
performance is all the more impressive given that businesses are
reported to have had to divert considerable resources toward
avoiding computer problems associated with the century date change, and
given as well that businesses may have had to hire less-skilled workers
than were available earlier in the expansion when the pool of potential
workers was not so shallow. Part of the strength in productivity growth
over the past few years may have been a cyclical response to the rapid
growth of output over this period. But productivity may also be reaping
a more persistent payoff from the boom in business investment and the
accompanying introduction of newer technologies that have occurred over
the past several years.

Even these impressive gains in labor
productivity may not have kept up fully with increases in firms' real
compensation costs of late. Over the past two years, real compensation,
measured by the ECI relative to the price of nonfarm business output,
has increased the same hefty 2-1/2 percent per year as
labor productivity; however, measured instead using nonfarm
compensation per hour, real compensation has increased somewhat more
than productivity over this period, implying a rising share of
compensation in total national income. A persistent period of real
compensation increases in excess of productivity growth would
reduce firms' capacity to absorb further wage gains without putting
upward pressure on prices.

Prices

Price inflation moved up in
early 1999 from a level in 1998 that was depressed by a
transitory drop in energy and other commodity prices. After increasing
only about 1-1/2 percent over 1998, the consumer price
index rose at a 2-1/4 percent annual rate over the first
six months of this year, driven by a sharp turnaround in prices of
gasoline and heating oil. However, the so-called ``core'' CPI,
which excludes food and energy items, rose at an annual rate of only
1.6 percent over this period--a somewhat smaller increase than
that registered over 1998 once adjustment is made for the
effects of changes in CPI methodology: According to a new research
series from the Bureau of Labor Statistics (BLS), the core CPI would
have increased 2.2 percent over 1998 had 1999 methods been in
place in that year. 4

The moderation of the core CPI in recent years
has reflected a variety of factors that have helped hold inflation in
check despite what has been by all accounts a very tight labor market.
Price increases have been damped by substantial growth in manufacturing
capacity, which has held plant utilization rates in most industries at
moderate (and in some cases subpar) levels, thereby reinforcing
competitive pressures in product markets. Furthermore, rapid
productivity growth helped hold increases in unit labor costs to low
levels even as compensation growth was picking up last year. The rise
in compensation itself has been constrained by moderate expectations of
inflation, which have been relatively stable. According to the
Michigan SRC survey, the median of one-year-ahead inflation
expectations, which was about 2-1/2 percent late last year,
averaged 2-3/4 percent in the first half of this year.

The quiescence of inflation expectations, at least through the
early part of this year, in turn may have come in part from the
downward movement in overall inflation last year resulting from
declines in prices of imports and of oil and other commodities.
These price declines have not been repeated more recently.
This year's rise in energy prices is the clearest example, but
commodity prices more generally have been turning up of late. The
Journal of Commerce industrial price index has moved up about 6
percent so far this year after having declined about 10 percent
last year, with especially large increases posted for prices of lumber,
plywood, and steel. These price movements are starting to be seen at
later stages of processing as well: The producer price index for
intermediate materials excluding food and energy, which gradually
declined about 2 percent over the fifteen months through February
1999, retraced about half of that decrease by June. Furthermore,
non-oil import prices, although continuing to fall this year, have
moved down at a slower rate than that of the past couple of years when
the dollar was rising sharply in foreign exchange markets. Non-oil
import prices declined at a 1-1/4 percent annual rate over
the first half of 1999, after having fallen at a 3 percent rate,
on average, over 1997 and 1998.

Some other broad measures of prices also showed evidence of
acceleration early this year. The chain-type price index for GDP--which
covers prices of all goods and services produced in the United
States--rose at about a 1-1/2 percent annual rate in the
first quarter, up from an increase of about 1 percent last year.
A portion of this acceleration reflected movements in the chain-type
price index for personal consumption expenditures (PCE) that differed
from movements in the CPI.

3.

Alternative measures
of price changePercent, annual rate

Price measure

1996:Q4
to
1997:Q4

1997:Q4
to
1998:Q4

1998:Q4
to
1999:Q1

Fixed weight

Consumer price index

1.9

1.5

1.5

Excluding food and energy

2.2

2.4

1.6

Chain type

Gross domestic product

1.7

0.9

1.6

Gross domestic purchases

1.3

0.4

1.2

Personal consumption expenditures

1.5

0.7

1.2

Excluding food and energy

1.6

1.2

1.3

Note. A fixed-weight index uses quantity weights from the
base year
to aggregate prices from each distinct item category.
A chain-type index is the
geometric average of two fixed-weight indexes and
allows the weights to
change each year.
Changes are based on quarterly averages.

Although the components of the CPI are key inputs into the PCE
price index, the two price measures differ in a variety of respects:
They use different aggregation formulas; the weights are derived from
different sources; the PCE measure does not utilize all components of
the CPI; and the PCE measure is broader in scope, including
not just the out-of-pocket expenditures by households that are captured
by the CPI, but also the portion of expenditures on items such as
medical care and education that are paid by insurers or governments,
consumption of items such as banks' checking services that are provided
without explicit charge, and expenditures made by nonprofit
institutions. Although PCE prices typically rise a bit less rapidly
than the CPI, the PCE price measure was unusually restrained relative
to the CPI in the few years through 1998, reflecting a combination of
the above factors.

Last year's sharp drop in retail energy prices and the subsequent
rebound this spring reflected movements in the price of crude oil. The
spot price of West Texas intermediate (WTI) crude oil, which had stood
at about $20 per barrel through most of 1997, dropped sharply over 1998
and reached $11 per barrel by the end of the year, reflecting in part a
weakening in demand for oil from the distressed Asian nations and
increases in supply from Iraq and other countries. But oil prices
jumped this year as the OPEC nations agreed on production restraints
aimed at firming prices, and the WTI spot price reached $18 per barrel
in April and has moved still higher more recently. As a result,
gasoline prices, which dropped 15 percent over 1998, reversed almost
all of that decline over the first six months of this year. Prices of
heating fuel also rebounded after dropping in 1998. In all, the CPI for
energy rose at a 10 percent annual rate over the December-to-June
period.

Consumer food prices increased moderately over the first six
months of the year, rising at a 1-3/4 percent annual rate.
Despite the upturn in commodity prices generally, farm prices
have remained quite low and have helped to hold down food price
increases. Spot prices of wheat, soybeans, and sugar have moved down
further this year from already depressed levels at the end of 1998, and
prices of corn and coffee have remained low as well.

The CPI for goods other than food and energy declined at about a
1/2 percent annual rate over the first six months of 1999,
after having risen 1-1/4 percent over 1998. The 1998
increase reflected a sharp rise in tobacco prices in December
associated with the settlement of litigation between the tobacco
companies and the states; excluding tobacco, the CPI for core goods was
about flat last year. The decline in the first half of this year was
concentrated in durable goods, where prices softened for a wide range
of items, including motor vehicles. The CPI for non-energy services
increased about 2-1/2 percent at an annual rate in the
first half, down a little from the increase over 1998. Increases in the
CPI for rent of shelter have slowed thus far in 1999, rising at a
2-1/2 percent annual rate versus a 3-1/4
percent rise last year. However, airfares and prices of medical
services both have been rising more rapidly so far this year.

Debt and the Monetary Aggregates

Debt and Depository Intermediation

The total debt of the U.S. household,
government, and nonfinancial business sectors increased at about a
6 percent annual rate from the fourth quarter of 1998 through
May, a little above the midpoint of its growth range of 3 percent
to 7 percent. Nonfederal debt expanded briskly at about a 9
percent annual pace, in association with continued strong private
domestic spending on consumer durable goods, housing, and business
investment. By contrast, federal debt contracted at a 3 percent
annual rate, as budget surpluses reined in federal government financing
needs.

Credit extended by depository institutions slumped over the first
half of 1999, after having expanded quite briskly in 1998. A fair-sized
portion of the expansion in 1998 came in the fourth quarter and stemmed
from the turmoil in financial markets. In that turbulent environment,
depository institutions postponed securitization of mortgages, and
businesses shifted their funding demand from securities markets to
depository institutions, where borrowing costs in some cases were
governed by pre-existing lending commitments. Depository institutions
also acquired mortgage-backed securities and other private debt
instruments in volume, as their yields evidently rose relative to
depository funding costs. As financial stresses unwound,
securitization resumed, business borrowers returned to securities
markets, and net purchases of securities slowed. From the fourth
quarter of 1998 through June, bank credit rose at a 3 percent
annualized pace, after adjusting for the estimated effects of
mark-to-market accounting rules.

Monetary Aggregates

The growth of M3, the
broadest monetary aggregate, slowed appreciably over the first half of
1999. M3 expanded at a 6 percent annual pace from the fourth
quarter of 1998 through June of this year, placing this aggregate at
the top of the 2 percent to 6 percent price-stability
growth range set by the FOMC at its February meeting. With depository
credit growing modestly, depository institutions trimmed the managed
liabilities included in M3, such as large time deposits.
Growth of institutional money market mutual funds also moderated from
its rapid pace in 1998. Rates on money market funds tend to lag the
movements in market rates because the average rate of return on the
portfolio of securities held by the fund changes more slowly than
market rates. In the fall, rates on institutional money market funds
did not decline as fast as market rates after the Federal Reserve eased
monetary policy, and the growth of these funds soared. As rates on
these funds moved back into alignment with market rates this year,
growth of these funds ebbed.

M2 advanced at a 6-1/4 percent
annual rate from the fourth quarter of 1998 through June. M2 growth had
been elevated in late 1998 by unsettled financial conditions, which
raised the demand for liquid money balances, and by the easing of
monetary policy, which reduced the opportunity costs of holding the
assets included in the monetary aggregates. M2 growth moderated over
the first half of 1999, as the heightened demand for money waned; in
June this aggregate was above its 1 percent to 5 percent
price-stability growth range. The growth in M2 over the first half of
the year again outpaced that of nominal income, although the decline in
M2 velocity--the ratio of nominal income to M2--was at a slower rate
than in 1998. The decline this year reflected in part a
continuing lagged response to the policy easing in the fall; however,
the drop in M2 velocity was again larger than predicted on the basis of
the historical relationship between the velocity of M2 and the
opportunity costs of holding M2--measured as the difference between the
rate on three-month Treasury bills and the average return on M2 assets.
The reasons for the decline of M2 velocity this year are
not clear; the drop extends a trend in velocity evident since
mid-1997 and may in part owe to households' efforts to allocate some
wealth to the assets included in M2, such as deposits and money market
mutual fund shares, after several years of substantial gains in equity
prices that greatly raised the share of wealth held in equities.

M1 increased at a 2 percent annualized
pace from the fourth quarter of 1998 through June, in line with its
advance in 1998. The currency component of M1 expanded quite rapidly.
The strength appeared to stem from domestic, rather than foreign,
demand, perhaps reflecting vigorous consumer spending, although
currency growth was more robust than might be expected for the rise in
spending. The deposits in M1--demand deposits and other checkable
deposits--contracted further, as retail sweep programs continued to be
introduced. These programs, which first began in 1994, shift funds from
a depositor's checking account, which is subject to reserve
requirements, to a special-purpose money market deposit account,
which is not. Funds are then shifted back to the checking account when
the depositor's account balance falls below a given level. The
depository institution benefits from a retail sweep program because the
program cuts its reserve requirement and thus the amount of
non-interest-bearing reserve balances that it must hold at its Federal
Reserve Bank. New sweep programs depressed the growth of M1 by about
5-1/4 percentage points over the first half of 1999,
somewhat less than in previous years because most of the
depository institutions that would benefit from such programs had
already implemented them.

4.

Growth of money and
debtPercent

Period

M1

M2

M3

Domestic nonfinancial
debt

Annual1

1989

0.6

5.2

4.1

7.5

1990

4.2

4.2

1.9

6.7

1991

8.0

3.1

1.2

4.5

1992

14.3

1.8

0.6

4.5

1993

10.6

1.3

1.0

4.9

1994

2.5

0.6

1.7

4.9

1995

-1.6

3.9

6.1

5.4

1996

-4.5

4.6

6.8

5.1

1997

-1.2

5.8

8.8

4.8

1998

1.8

8.5

10.9

6.1

Quarterly (annual
rate)2

1999 Q1

2.8

7.2

7.3

5.9

Q2

3.4

5.7

5.0

Year-to-date (annual
rate)3

1999

2.0

6.2

6.0

6.1

Note. M1 consists of currency,
travelers checks,
demand deposits, and other
checkable deposits. M2 consists
of M1 plus savings deposits (including
money market deposit
accounts), small-denomination time deposits, and
balances
in retail money market funds. M3 consists of M2 plus
large-denomination time deposits, balances in institutional
money
market funds, RP liabilities (overnight and term),
and Eurodollars
(overnight and term). Debt consists of the
outstanding credit market debt of the U.S.
government,
state and local governments, households and nonprofit
organizations, nonfinancial businesses, and farms.
1. From average for fourth
quarter of preceding year to average for fourth quarter
of year indicated.
2. From average for preceding quarter to
average
for quarter indicated.
3. From average for
fourth quarter of 1998 to average
for June (May in the case of domestic nonfinancial debt).

As a consequence of retail sweep programs, the balances that
depository institutions are required to hold at the Federal Reserve
have fallen about 60 percent since 1994. This development has the
potential to complicate reserve management by the Federal Reserve and
depository institutions and thus raise the volatility of the federal
funds rate. It would do so by making the demand for balances at
the Federal Reserve more variable and less predictable. Before the
introduction of sweeps, the demand for balances was high and stable
because reserve balance requirements were large, and the
requirements were satisfied by the average of daily balances held
over a maintenance period. With sweep programs reducing required
balances to low levels, depository institutions have found that they
target balances in excess of their required balances in order to gain
sufficient protection against unanticipated debits that could leave
their accounts overdrawn at the end of the day. This payment-related
demand for balances varies more from day to day than the
requirement-related demand. Thus far, the greater variation in the
demand for balances has not made the federal funds rate appreciably
more volatile, in part reflecting the successful efforts of depository
institutions and the Federal Reserve to adapt to lower balances. For
its part, the Federal Reserve has conducted more open market operations
that mature the next business day to better align daily supply
with demand. Nonetheless, required balances at the Federal Reserve
could drop to levels at which the volatility of the funds rate becomes
pronounced. One way to address the problem of declining required
balances would be to permit the Federal Reserve to pay interest on the
reserve balances that depository institutions hold. Paying interest on
reserve balances would reduce considerably the incentives of depository
institutions to develop reserve-avoidance practices that may
complicate the implementation of monetary policy.

U.S. Financial Markets

Yields on Treasury securities have risen this year in response to
the ebbing of the financial market strains of late 1998, surprisingly
strong economic activity, concerns about the potential for increasing
inflation, and the consequent anticipation of tighter monetary policy.
In January, yields on Treasury securities moved in a narrow range, as
lingering safe-haven demands for dollar-denominated assets, owing in
part to the devaluation and subsequent floating of the Brazilian
real, about offset the effect on yields of
stronger-than-expected economic data. Over subsequent months, however,
yields on Treasury securities, especially at intermediate and long
maturities, moved up substantially. The demand for the safest and most
liquid assets, which had pulled down Treasury yields in the fall,
abated as the strength in economic activity and favorable earnings
reports engendered optimism about the financial condition of
private borrowers and encouraged investors to buy private
securities. In addition, rising commodity prices, tight labor markets,
and robust economic activity led market participants to conclude
that monetary policy would need to be tightened, perhaps in a
series of steps. This view, accentuated by the FOMC's announcement
after its May meeting that it had adopted a directive tilted
toward tightening policy, also boosted yields. Between the end of
1998 and mid-July, Treasury yields added about 80 basis points to
110 basis points, on balance, with the larger increases in the
intermediate maturities. The rise in Treasury bill rates, anchored
by the modest upward move in the FOMC's target federal funds rate, was
much less, about 10 basis points to 40 basis points.

The recovery in fixed-income markets over the first half of the
year was evident in a number of indicators of market conditions. Market
liquidity was generally better, and volatility was lower. The relative
demand for the most liquid Treasury securities--the most recently
auctioned security at each maturity--was not so acute, and yields on
these securities were in somewhat closer alignment with yields on
issues that had been outstanding longer. Dealers were more willing to
put capital at risk to make markets, and bid-asked spreads in Treasury
securities narrowed somewhat, though, in June they were still a bit
wider than had been typical. Market expectations of asset price
volatility, as reflected in prices on Treasury bond options contracts,
receded on balance. The implied volatility of bond prices dropped off
until April and then turned back up, as uncertainty about the timing
and extent of a possible tightening of monetary policy increased.

Yields on inflation-indexed Treasury securities
have only edged up this year, and the spreads between yields on nominal
Treasury securities and those on comparable inflation-indexed
securities have widened considerably. Yields on inflation-indexed
securities did not decline in late 1998 like those of their nominal
counterparts, in part because these securities were not perceived as
being as liquid as nominal Treasury securities. Thus, as the safe-haven
demand for nominal Treasury securities unwound and nominal yields rose,
yields on inflation-indexed securities did not move up concomitantly.
Moreover, these yields were held down by some improvement in the
liquidity of the market for inflation-indexed securities, as
suggested by reports of narrower bid-asked spreads, which provided
additional impetus for investors to acquire these securities.
Because of such considerations, the value of the yield spread
between nominal and inflation-indexed Treasury securities as
an indicator of inflation expectations is limited. Nonetheless, the
widening of the spread this year may have reflected some rise
in inflation expectations.

Equity prices have climbed
this year. Major equity price indexes posted gains of 10 percent
to 31 percent, on balance, between the end of 1998 and July
16, when most of them established record highs. The lift to prices from
stronger-than-anticipated economic activity and corporate profits
apparently has offset the damping effect of rising bond yields. Prices
of technology issues, especially Internet stocks, have risen
considerably on net, despite some wide swings in sentiment. Share
prices of firms producing primary commodities, which tumbled in the
fall, rebounded to post large price gains, perhaps because of the
firming of commodity prices amid perceptions that Asian economies were
improving. Consensus estimates of earnings over the coming twelve
months have strengthened, but in June the ratio of these
estimates to prices, as measured by the S&P 500 index,
was near the record low established in May. Meanwhile, real interest
rates, measured as the difference between the yield on the nominal
ten-year Treasury note and a survey-based measure of inflation
expectations, moved up. Consequently, the risk premium for holding
equities remained quite small by historical standards.

Year 2000 Preparedness

The Federal Reserve and the banking system have largely completed
preparing technical systems to ensure that they will function at
the century date change and are taking steps to deal with potential
contingencies. The Federal Reserve successfully completed testing all
of its mission-critical computer systems for year 2000
compliance, including its securities and funds transfer systems. As a
precaution to assure the public that sufficient cash will be available
in the event that demand for U.S. currency rises in advance of
the century date change, the Federal Reserve will increase considerably
its inventory of currency by late 1999. In addition, the Federal
Reserve established a Century Date Change Special Liquidity Facility to
supply collateralized credit freely to depository institutions at a
modest penalty to market interest rates in the months surrounding the
rollover. This funding should help financially sound depository
institutions commit more confidently to supplying loans to other
financial institutions and businesses in the closing months of 1999 and
early months of 2000.

All depository institutions have been subject to special
year 2000 examinations by their banking supervisors to ensure
their readiness. Banks, in turn, have worked with their customers to
encourage year 2000 preparedness by including a review of a
customer's year 2000 preparedness in their underwriting or
loan-review standards and documentation. According to the Federal
Reserve's May 1999 Senior Loan Officer Opinion Survey, a substantial
majority of the respondent banks have largely completed year 2000
preparedness reviews of their material customers. Most banks reported
that only a small portion of their customers have not made satisfactory
progress.

Banks in the Federal Reserve's survey reported little demand from
their clients for special contingency lines of credit related to the
century date change, although many expect demand for such lines to
increase somewhat as the year progresses. Almost all domestic
respondents reported that they are willing to extend such credit lines,
although in some cases with tighter standards or terms.

International Developments

Global economic prospects look considerably
brighter than they did only a few months ago. To an important
degree, this improvement owes to the rebound in the Brazilian
economy from the turmoil experienced in January and February and to the
fact that the fallout from Brazil on other countries was much less than
it might have been. The fear was that the collapse of the Brazilian
real last January would unleash a spiral of inflation and
further devaluation and lead to a default on government domestic debt,
destabilizing financial markets and triggering an intensified
flight of capital from Brazil. In light of events following the Russian
debt moratorium and collapse of the ruble last year, concern existed
that a collapse of the real could also have negative
repercussions in Latin America more broadly, and possibly even in
global financial markets.

Developments in Brazil turned out better than expected over the
weeks after the floating of the real in January. Between
mid-January and early March, the real lost 45 percent
of its value against the dollar, reaching a low of 2.2 per dollar, but
then started to recover after the Brazilian central bank raised the
overnight interest rate from 39 percent to 45 percent and
made clear that it gave a high priority to fighting inflation. By
mid-May, the real had strengthened to 1.65 per dollar,
even while the overnight rate had been cut, in steps, from
its March high. The overnight rate was reduced further, to 21
percent by the end of June, but the real fell back only
modestly and stood at about 1.80 per dollar in mid-July. Brazil's stock
market also rose sharply and was up by about 65 percent in the
year to date.

Several favorable developments have worked to support the
real and equity prices over the past few months.
Inflation has been lower than expected, with consumer price inflation
at an annual rate of around 8 percent for the first half of the
year. Greater-than-expected real GDP growth in the first quarter,
though attributable in part to temporary factors, provided some
evidence of a bottoming out, and possible recovery, in economic
activity over the first part of this year. And in the fiscal arena, the
government posted a primary surplus of more than 4 percent of GDP
in the first quarter--well above the goal in the International Monetary
Fund program. The positive turn of events has facilitated a return of
the Brazilian government and private-sector borrowers to international
bond markets, albeit on more restrictive terms than those of a year
ago.

Since the middle of May, however, the road to recovery in Brazil
has become bumpier. The central government posted a fiscal deficit in
May that was bigger than had been expected. In addition, court
challenges have called into question fiscal reforms enacted earlier
this year that were expected to improve the government's fiscal balance
by about 1 percent of GDP. In May, the rise in U.S. interest
rates associated with the anticipated tightening in the stance of U.S.
monetary policy helped push Brady bond yield spreads up more than 200
basis points. Although they narrowed some in June they widened recently
on concerns about Argentina's economic situation.

The Brazilian crisis did trigger renewed financial stress
throughout Latin America, as domestic interest rates and Brady bond
yield spreads increased sharply in January from levels that had already
been elevated by the Russian crisis. Nonetheless, these increases were
generally smaller than those that had followed the Russian crisis, and
as developments in Brazil proved more positive than expected, financial
conditions in the rest of the region stabilized rapidly. Even so, the
combination of elevated risk premiums and diminished access to
international credit markets, as well as sharp declines in the
prices of commodity exports, had significant consequences for GDP
growth, which began to slow or turn negative throughout the region in
late 1998 and early 1999.

Mexico appears to have experienced the least diminution in
economic growth, likely because of its strong trade links with the
United States, where growth has been robust. A flattening in Mexican
GDP in the final quarter of 1998 has given way to renewed, but
moderate, growth more recently, and the Mexican peso has appreciated by
about 5-1/2 percent relative to the dollar since the start
of the year. By contrast, economic activity in Argentina declined
sharply in the first quarter, in part because of the devaluation and
relatively weak economic activity in Brazil, Argentina's
major trading partner. More recently the earlier recovery in
Argentina's financial markets appears to have backtracked as concern
has increased about the medium- to long-run viability of the currency
peg to the dollar. Several countries in the region, including
Venezuela, Chile, and Colombia, also experienced sharp declines in
output in the first quarter, stemming in part from earlier declines in
oil and other commodity prices.

In emerging Asia, signs of recovery in financial markets and in
real activity are visible in most of the countries that experienced
financial crises in late 1997. However, the pace and extent of recovery
is uneven across countries. The strongest recovery has been in Korea.
In 1998, the Korean won reversed nearly half of its sharp depreciation
of late 1997. It has been little changed on balance this year, as
Korean monetary authorities have intervened to moderate its further
appreciation. Korean stock prices have also staged an impressive
recovery--moving up about 75 percent so far in 1999. In the wake
of its financial crisis, output in Korea fell sharply, with industrial
production down about 15 percent by the middle of last year.
Since then, however, production has bounced back. With the pace of the
recovery accelerating this year, all of the post-crisis drop in
production has been reversed. This turnaround reflects both the
improvement in Korea's external position, as the trade balance has
swung into substantial surplus, and the government's progress in
addressing the structural problems in the financial and corporate
sectors that contributed to the crisis.

Financial markets in the Southeast Asian countries that
experienced crises in 1997 (Thailand, Singapore, Malaysia, Indonesia,
and the Philippines) apparently were little affected by spillover from
Brazil's troubles earlier this year and have recovered on balance over
the past year, with exchange rates stabilizing and stock prices moving
higher. Financial conditions have been weakest in Indonesia, in large
part a result of political uncertainty; but even so, domestic interest
rates have dropped sharply, and the stock market has staged an
impressive rebound since April. The recovery of economic activity in
these countries has been slower and less robust than in Korea, possibly
reflecting slower progress in addressing structural
weaknesses in the financial and corporate sectors. However, activity
appears to have bottomed out and has recently shown signs of starting
to move up in these countries.

Financial markets in China and Hong Kong
experienced some turbulence at the start of the year when Chinese
authorities put the Guangdong International Trust and Investment
Corporation (GITIC) into bankruptcy, leading to rating downgrades for
some Chinese financial institutions, including the major state
commercial banks. The GITIC bankruptcy also raised concerns about Hong
Kong financial institutions, which are heavy creditors to Chinese
entities. These concerns contributed to a substantial increase in yield
spreads between Hong Kong government debt and U.S. Treasury securities
and to a fall in the Hong Kong stock market of about 15 percent.
Spreads have narrowed since, falling from about 330 basis points on
one-year debt in late January to about 80 basis points by
mid-May, and have remained relatively stable since then. Equity prices
also rebounded sharply, rising nearly 50 percent between
mid-February and early May. Despite sizable volatility in May and June,
they are now roughly unchanged from early May levels.

In Japan, a few indicators suggest that recovery from a prolonged
recession may be occurring. Principally, first-quarter GDP growth at an
annual rate of 7.9 percent was recorded--the first positive
growth in six quarters. This improvement reflects in part a shift
toward more stimulative fiscal and monetary policies. On the fiscal
front, the government announced a set of measures at the end of last
year that were slated for implementation during 1999 and
included permanent cuts in personal and corporate income taxes, various
investment incentives, and increases in public expenditures. The
large-scale fiscal expansion and concern about increases in the supply
of government bonds caused bond yields to more than double late last
year and early this year, to a level of about 2 percent on the
ten-year bond.

In mid-February, primarily because of concern about the prolonged
weakness in economic activity and pronounced deflationary pressures but
also in response to the rising bond yields, the Bank of Japan announced
a reduction in the target for the overnight call-money rate and
subsequently guided the rate to its present level of 3 basis points by
early March. This easing of monetary policy had a stimulative effect on
Japanese financial markets, with the yield on the ten-year government
bond falling more than 75 basis points, to 1.25 percent by
mid-May. More recently, the yield has risen to about 1.8 percent,
partially in response to the release of unexpectedly strong
first-quarter GDP growth. Supportive monetary conditions, coupled with
restructuring announcements from a number of large Japanese firms and
growing optimism about the economic outlook, have fueled a rise in the
Nikkei from around 14,400 over the first two months of the year to over
18,500 in mid-July.

The improved economic performance in Japan also reflects some
progress on addressing persistent problems in the financial sector. In
March the authorities injected 7-1/2 trillion yen of public
funds into large financial institutions and began to require increased
provisioning against bad loans as well as improved financial
disclosure. Although much remains to be done, these actions appear to
have stabilized conditions, at least temporarily, in the banking
system, and the premium on borrowing rates paid by leading Japanese
banks declined to zero by March.

The yen strengthened in early January, supported by the runup in
long-term Japanese interest rates, reaching about 110 per dollar--its
highest level in more than two years. However, amid apparent
intervention by the Japanese authorities, the yen retreated to a
level above 116 per dollar, and it remained near that level until the
mid-February easing of monetary policy and the subsequent decline of
interest rates when it depreciated to about 120 per dollar. In
mid-June, the Japanese authorities intervened in the foreign exchange
market in an effort to limit appreciation of the yen after the
surprisingly strong first-quarter GDP release increased market
enthusiasm for that currency. The authorities noted that a premature
strengthening of the yen was undesirable and would weigh adversely on
economic recovery.

In the other major industrial countries, the pace of
economic growth this year has been mixed. Economic developments in
Canada have been quite favorable. GDP rose 4-1/4 percent at
an annual rate in the first quarter after a fourth-quarter gain
of 4-3/4 percent, with production fueled by strong demand
for Canadian products from the United States. Core inflation remains
low, near the lower end of the Bank of Canada's target range of
1 percent to 3 percent, although overall inflation rose
some in April and May. Oil prices and other commodity prices have
risen, and the current account deficit has narrowed considerably. These
factors have helped the Canadian dollar appreciate relative to the U.S.
dollar by about 4 percent this year and have facilitated a cut in
short-term interest rates of 50 basis points by the Bank of Canada.
Along with rising long-term interest rates elsewhere, long rates have
increased in Canada by about 30 basis points over the course of this
year. Even so, equity prices have risen about 12 percent since
the start of the year, although the rise in long-term rates has
undercut some of the momentum in the stock market.

In the United Kingdom, output was flat in the first quarter,
coming off a year in which GDP growth had already slowed markedly.
However, the effects of aggressive interest rate reductions undertaken
by the Bank of England in late 1998 and earlier this year appear to
have emerged in the second quarter, with gains in industrial
production, retail sales volume, and business confidence. Inflationary
pressures have been well contained, benefiting in part from the
continued strength in sterling; the Bank of England cut interest rates,
most recently in June, to reduce the likelihood of inflation
undershooting its target of 2-1/2 percent. Consistent with
expectations of an upturn in growth, equity prices have risen more than
15 percent, and long-term bond yields have climbed nearly 80
basis points since the end of last year.

First-quarter growth in the European countries that have adopted
a common currency (euro area) regained some momentum from its slow
pace in late 1998 but was nevertheless below potential, as production
continued to react to the decline in export orders registered over the
course of 1998 and in early 1999. Still, the drag on overall production
from weak export demand from Asia and eastern Europe appears to have
lifted a bit in the past few months, although the signs of a pickup in
growth were both tentative and uneven across the euro area. In
Germany, industrial production was higher in April and May than in the
preceding two months, and export orders were markedly higher in those
months than they had been at any time since the spring of 1998. But in
France, which had been the strongest of the three largest euro-area
economies in 1998, GDP growth was a meager 1-1/4 percent at
an annual rate in the first quarter, and industrial production slipped
in April.

On average in the euro area, inflation has remained quite tame,
even as rising oil prices, a declining euro, and, at least in Germany,
an acceleration in wage rates have raised inflationary pressures this
year. The low average rate of inflation as well as the still sluggish
pace of real activity in some of the euro-area countries led the
European Central Bank to lower the overnight policy rate by 50 basis
points in April, on top of cuts in short-term policy rates made by the
national central banks late last year that, on average, were worth
about 60 basis points.

Notwithstanding the easing of the policy stance, long-term
government bond yields have risen substantially from their January lows
in the largest economies of the euro area. Ten-year rates spiked in
early March along with U.S. rates, fell back some through mid-May, and
then resumed an upward course around the time the FOMC adopted a
tightening bias in mid-May. Since the middle of June, a relatively
sharp increase in yields has pushed them to about 100 basis points
above their values at the start of the year and has narrowed what had
been a growing interest rate differential between U.S. and European
bonds. In addition to the pressure provided by the increase in U.S.
rates, the runup in European yields likely reflects the belief that
short-term rates have troughed, as the incipient recovery in Asia not
only reduces the drag on European exports but also attenuates
deflationary pressures on European import prices. Concern about the
fall in the exchange value of the euro may also have contributed to an
assessment that the next move in short-term rates would be up. Gains in
equity prices so far this year--averaging about 12-1/2
percent--are also suggestive of the belief that economic activity may
be picking up, although the range in share price movements is fairly
broad, even considering only the largest economies: French equity
prices have risen about 20 percent, German prices are up 13
percent, and Italian prices are up only 5 percent.

The new European currency, the euro, came into
operation at the start of the year, marking the beginning of Stage
Three of European Economic and Monetary Union. The rates of exchange
between the euro and the currencies of the eleven
countries adopting the euro were set on December 31; based on
these rates, the value of the euro at the moment of its creation was
$1.16675. Trading in the euro opened on January 4, and after jumping on
the first trading day, its value has declined relative to the dollar
almost steadily and is now about 13 percent below its initial
value. The course of the euro-dollar exchange rate likely has
reflected in part the growing divergence in both the cyclical positions
and, until recently, long-term bond yields of the euro-area economies
and the United States. Concerns about fiscal discipline in Italy--the
government raised its 1999 deficit-to-GDP target from 2.0
percent to 2.4 percent--and about progress on
structural reforms in Germany and France have also been cited as
contributing to weakness in the euro, with the European Central Bank
recently characterizing national governments' fiscal policy plans
as ``unambitious.''

On balance the dollar has appreciated more than 4-1/2
percent against an index of the major currencies since the end of last
year, owing mainly to its strengthening relative to the euro.
Nevertheless, it remains below its recent peak in August of last year
when the Russian debt moratorium and subsequent financial market
turmoil sent the dollar on a two-month downward
slide.

Footnotes

1. All figures from the national income and product accounts cited here are subject to change in the quinquennial benchmark
revisions slated for this fall. Return to text

2. However, nonfarm compensation per hour captures the gains from the actual exercise of stock options, whereas for
analyzing compensation trends, one might prefer to measure the value of
the options at the time they are granted. Return to text

3. About 1/4 percentage point of the improvement
in productivity growth since 1995 can be attributed to changes in price
measurement. The measure of real output underlying the productivity
figures since 1995 is deflated using CPI components that have been
constructed using a geometric-means formula; these components tend to
rise less rapidly than the CPI components that had been used in the
output and productivity data before 1995. These smaller CPI increases
translate into more rapid growth of output and productivity in the
later period. Return to text

4. The most important change this year was the introduction of the geometric-means formula to aggregate price quotes within most of
the detailed item categories. (The Laspeyres formula continues to be
used in constructing higher-level aggregates.) Although these
geometric-means CPIs were introduced into the official CPI only in
January of this year, the BLS generated the series on an experimental
basis going back several years, allowing them to be built into the
national income and product accounts back to 1995. Return to text